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Sun 11 Oct 2015 10:56 AM

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Understanding working capital

We look at what working capital is, how to use it and where to get it

Understanding working capital

If you want your business to grow, expand operations, weather financial fluctuations, or even just survive those difficult early months, you won’t want to ignore working capital.

So often the life line for companies, working capital is a financial metric which represents the operating liquidity available to a business. If you have it, and manage it wisely, it can help you satisfy both short-term and long-term goals, but if you take your eye off the ball, its absence can put you and your business in dire straits.

What is working capital?

In basic terms, working capital is calculated by subtracting you current liabilities from your current assets. The resulting figure – your net working capital – serves as an indicator of your company’s ability to meet its short-term financial obligations, i.e. debt.

From a financing perspective, working capital refers to investment in two types of assets.

The first is a business’s investment in short-term assets needed to operate over a normal business cycle. This corresponds to the required investment in cash, accounts receivable, inventory, and other items listed as current assets on the firm’s balance sheet.

Here, working capital is about how a firm finances its current assets, but the second meaning is broader; referring to the company’s overall non-fixed asset investments.

Because businesses will often need to finance activities that do not involve assets measured on the balance sheet, working capital can represent a view of a firm’s capital needs that includes current assets and other non-fixed asset investments related to its operations.

Among your short-term assets can be inventories, loans, advances, debtors, investments and cash and bank balances. Short-term liabilities can include creditors, trade advances, borrowings and provisions.

What is it used for?

Perhaps the most critical use of working capital is providing ongoing investment in short-term assets that a business needs to operate.

There has to be a minimum cash balance to pay for everyday expenses and to provide a reserve for unexpected costs.

Your business will also need working capital for repaid business costs such as licences, insurance or security deposits.

Another purpose of working capital is addressing seasonal or cyclical financing needs. Here is supports the build-up of short-term assets needed to generate revenue but which come before the receipt of cash.

Because many businesses don’t receive payment before providing goods and services, they need to finance the purchase, production, sale and collection costs prior to receiving payment from customers.

The working capital will ensure your company can pay its bills before taking receipt of payment. If it’s not managed appropriately, you could quite easily run out of cash and face bankruptcy.

As your business grows you will most likely need larger investments in inventory, accounts receivable, personnel, and more, so you will need to finance the working capital as required.

Another use if to undertake activities to improve business operations and remain competitive. This can mean product development, cultivating new markets, and so on. Due to the nature of competition and the evolution of your sector, these costs are likely to be small and frequently repeated.

Where does it come from?

The three main sources are equity, cash advances, and bank loans.

Commercial banks are a large financing source for business debt, including working capital loans, and offer a wide range of debt products. Most will focus on lending to small businesses with large borrowing needs and limited risks.

Other financial institutions are more willing to make higher risk loans, and some even specialise in serving specific industries, allowing them to better asses risk and creditworthiness, meaning they might be prepared to offer loans that more general lenders wouldn’t.

Venture capital firms also finance working capital, often in order to support rapid growth, and typically provide equity financing or debt capital.

Another option to consider is government initiatives.

Usually offering smaller amounts, programmes such as Dubai SME and Khalifa Fund for Enterprise Development can provide loans to start-ups that do not qualify for conventional working capital credit.

Finally, credit funding is another avenue for many entrepreneurs, using personal credit sources such as credit cards, mortgage loans, and the like. The risks, however, can be very high due to the blurring of the lines between personal and business assets, and the high interest can mean a reduction of cash flow.

For information, tips and advice on setting up a new business or insights from those who have taken the leap into the world of entrepreneurship, click on the Arabian Business StartUp section.

 

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